Ever wondered how you earn interest on your savings account? Chances are it’s not keeping you up at night, but here’s a simple guide for you to work out your savings potential.
There are three important things used to calculate interest on your cash – the principal, interest rate and time.
The principal is essentially the amount you have in savings to gain interest. It is recommended that households keep about two months of salary as a rainy day fund.
2. Interest rate
This is the rate offered by your financial institution, and is the percentage of your principal that will become interest every year.
- Simple interest
This is interest paid only on the original amount invested. For example, if you have $5,000 in savings (principal) at a 4 per cent rate for six years, your interest earned will be: $5,000 x 0.04 x 6 = $1,200. However, this assumes that you spend your interest as soon as you gain it, rather than keep it in your savings account.
- Compound interest
This is described as ‘interest on interest’. The more frequently interest is paid and reinvested into an account, the greater the final return. This is called compounding, which means interest is being paid on the interest reinvested. In other words, if you leave your savings untouched, then they will grow much faster.
For instance, if you invested $10,000 for one year at a 7 per cent per annum, and interest is paid quarterly and reinvested, at the end of the year you’ll have earned $175. That’s because $10,000 x 0.07 x (3 / 12) = $175.
How long you save for is just as important in determining your earnings as your interest rate. For example, keeping your cash in a high-rate account for only one year will likely earn you less than if you kept it in a lower-interest account for two years.
- Other factors
With RateCity’s savings account calculator, you can pinpoint your return with even more accuracy. For example, you can calculate the impact of additional deposits, such as salaries.
So experiment with different scenarios and savings methods to see what kind of difference healthy habits can have on your balance. And when you are done calculating, make numbers into reality by searching online for the best rates on savings accounts.